Damaged collateral

The LTRO operation of late December by the ECB has relieved some tensions on money markets and bank funding cost in the short term. Indeed, libor spreads have come in considerably while certain government bonds have had a serious rally versus the core led by Bund. It doesn’t stop quite there and the ECB is preparing another set of measures next to LTRO 2.0 end of February. And this time it involves quality standards and the core of the European way of executing banking operations

The European financial sector – in contrast to the US practice of dependence on retail deposits – is still very much reliant on external sources of funding next to traditional retail/savings deposits : wholesale funding and more importantly, financing through repo-operations. The latter means you make a term sale of an asset (eg government bond) at a price discounted by an interest rate (repo rate) over the term. At the same time, you are committed to repurchase the asset on a specific date in the future. This process can be continued indefinitely, as long as your asset is accepted as collateral and if the price/repo rate is all right. Repo activity can give you various insights. At the start of 2007 for example, the ECB presided by Trichet was worried about the significant increase in repo activity from 2006 onwards, hence the Trichet 2007 Davos alarm. People were convinced that the money multiplier through repo activity was going through the roof, hence too fast and a symptom of private sector banking leverage (“it takes money to make money”).

Today we have a different story because despite the improvement on the money market, repo activity has severely dropped in European banking. Some might say that this is an indicator of a weak business cycle and/or a credit crunch kicking in. An other possibility is that banks hold on to their quality assets (German Bund) in view of depressing secondary market government bond activity. And this might explain why at one stage, short term yields went negative late 2011 (no sellers and lots of demand for quality repo purposes). The following charts show the size of deceleration in main European repo activity.

But there is another aspect as well, ie the quality of the asset being put in repo and the acceptance of it by the counter party. And here we have a problem in view of downgrades of several government bonds, making them repo a more difficult and more costly exercise. And so the ECB steps in with the following proposal : To widen the pool of eligible collateral, meaning less quality assets or products for which secondary activity is problematic. Note that this is in a certain way similar to what the FED did during QE1 with various programs of outright buying of Mortgage backed securities from banks. Also bank loans or asset backed securities such as CLOs (collateralized loan obligations) could come into consideration. Some estimates seem to indicate that this would enlarge the bank funding market by some 10,000 bio EUR : Always welcome to repo at the ECB (national central banks) seems to be the adagium going forward.

But it is not a straightforward matter to implement this. The ECB is not pushing for it and invites EMU national central bank members to implement it on a voluntary basis. Indeed, some have already voiced not to participate : the Buba – no surprise here – already voiced that German banks don’t need to borrow more from the ECB. And if several opt out of the idea, it creates a paradox to the extent that we have a 2 speed banking system in 1 currency union. Central banks that take part immediately admit there is a national problem and identify themselves as the weakest link in the euro-zone banking system. And …